Wednesday, 20 May 2009

A catechism for a system that endures

By Samuel Brittan
Published: April 30 2009 19:44 Last updated: April 30 2009 19:44

Capitalism is not a system that some government decided to install, as the Soviet leaders did with “socialism”. It evolved over many years. Once established, governments of many different stripes could try to copy it, with widely varying results. There has been a long cycle among opponents, who begin by declaring it immoral, go on to predict its inevitable collapse and, when that does not happen, return to its supposed immorality. The system will continue but with a less overblown financial sector.
One of the myths about the system is that it is just about markets and prices. Visitors to the most remote villages in the developing world have often remarked on the ubiquity of market activities. Successful capitalism requires a great deal more. At a minimum it also requires:
1. A basis for long-term contracts. Such contracts in turn require:
2. The rule of law. This does not just mean judges in wigs or parliamentary assemblies. It means generally understood rules of the game so that economic agents can make plans that will not be undermined by unpredictable political intervention, criminal action or any other destabilising activity.
3. A minimum of trust so that entrepreneurs and others can undertake projects without constantly looking over their shoulder to see that undertakings are observed, and that commercial partners are not looking for ways to renege on obligations or to twist their meaning.
4. So far, what has been said only defines mercantile societies going back to medieval city-states, Shakespeare’s Venice or even earlier. The word “capitalism” was popularised by Karl Marx in the middle of the 19th century to describe a world characterised by, among other things, “roundabout” methods of production involving structures such as factories, railways and steamships.
5. Capitalism depends on private ownership of the greater part – not necessarily the whole – of the means of production, distribution and exchange. Joseph Schumpeter, in a postscript added to the UK edition of his path-breaking Capitalism, Socialism and Democracy, remarked that only the nationalisation measures of the postwar Labour government counted as genuine socialist steps. All the rest, such as wage and price controls, trade restrictions or attempted “economic planning”, whether wise or unwise, could be found in many capitalist societies. The temporary state ownership of some banks does not count as state socialism so long as private banks are not prevented from starting up.
Some reformers have envisaged a market society based on workers’ co-operatives rather than traditional private ownership. This, for example, is what John Stuart Mill meant by socialism. Whether that is correct is a semantic matter. The point of substance is that although there have been individual successful examples of employee-owned enterprise, such as Britain’s John Lewis retail partnership or the Mondrag√≥n group in Spain’s Basque Country, there have been few, if any, examples of whole societies operated on these lines, outside of Tito’s Yugoslavia.and Cuba.
6. Capitalism works best when there is competition between producers. But the degree of competition varies immensely. Businessmen do not in practice always welcome competition and a commentator can be pro-capitalist without being pro-business. Free trade is best treated as part of the competition agenda rather than as a separate undiscussable good.
7. Successful capitalism requires a good deal of economic freedom, although not necessarily laisser faire. The defects of capitalism are often called market failures: things such as environmental overspills or inadequate provision of public services. Moreover, a market system does not even pretend to provide a just distribution of income and wealth, whatever that is. At different times observers have claimed to detect trends both to increasing concentration of income and wealth, and towards a levelling of differences. Vilfredo Pareto, the early 20th-century economist, claimed that in the very long run the pattern of pre-tax distribution is surprisingly stable. Contrary to what zealots claim, taxes and benefits can influence income and wealth distribution provided that care is taken not to kill the goose that lays the golden eggs.
8. The capitalist system requires at least the possibility of separating ownership from control. This has been facilitated by the rise of limited liability laws since about the middle of the 19th century. But the practice also give rise to what modern economists call the “principal agent problem”: how the owners can control the managers.
9. Although there is a variable and often high degree of ploughed-back profits, there must be provision for a capital market in which savers can lend to enterprises (and governments) whose investment needs exceed their own resources. Such arrangements, in turn, require a secondary market in paper titles to wealth, nowadays called stock exchanges.
10. Any market system requires a functioning money, both to avoid the wasteful complications of barter and to serve as a standard of value. It does not require literally zero inflation but cannot well cope with unpredictable wild fluctuations.
11. Capitalism also requires depositary institutions where people can store their money without hoarding it under the mattress.
“Boom and bust” has been a feature of capitalism from the beginning, originating partly in the alternation of moods of pessimism and optimism. Not all recessions originate in the financial sector but those that do have, on average, been more than twice as severe as those that do not.
The present credit crunch leaves more or less unaffected the arguments for and against the first seven principles affecting what is sometimes called the “real” side of the economy. But it calls into question present arrangements for 9, 10, 11 and aspects of 8 – what might be called the “financial side”. The mutual entanglement of savings and investment decisions, money creation and deposit banking, has caused much harm and there have been numerous ideas for separating them – my favourite being the proposal of Henry Simons, the US economist, for “narrow” banks that can hold only assets in cash, deposits with the central bank or short-term government securities and are therefore safe against a run. But it is not a panacea.
Clearly there will now be a trend back towards a more regulated type of capitalism, as in the 1930s. But not all the regulation will be very wise. The perennial problem of regulation is the concentration of producer interests, which makes for successful lobbying, and dispersion of consumer and general citizen interests, which are therefore more difficult to organise. Moreover, much discussion is vitiated by the assumption of omniscient and benevolent government instead of balancing market failure against government failure. There is a vast body of US writing on the subject known as “public choice” ignored by authors of fashionable critiques such as Nudge or Animal Spirits.
Another problem is that capitalism is nowadays global but regulation is still at the national level. The most difficult issues, however, arise on the moral side. The assumption that the pursuit of self-interest within the rules and conventions of society will also promote the public interest is not likely to survive – if only because the content of these rules is up for grabs. But it is all too likely to be succeeded by a mushy collectivist pseudo-altruism, in which jealousy and envy are given a free ride.
Perhaps something is to be learnt from the social market theorists of the postwar “German economic miracle”, who were by no means opposed to government intervention but had firm principles regarding its nature, purpose and duration. Personally, I would go further back still. I know that some financial types hate their subject being mixed up with alien topics such as the study of English literature. Yet more is to be learnt from the novelist Jane Austen, who took for granted the legitimacy of property titles but insisted that such rights had their obligations, than from modern tomes on business ethics.

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